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Homeowners have a lot of money tied up in their residences, and a home equity line of credit (HELOC) — a type of second mortgage that allows homeowners to access cash, as needed, based on the value of their home — is one way they can tap that equity. And considering that some HELOC rates start at below 3% right now (see the best rates you qualify for here, and below), many people are taking out these loans to pay for home improvement projects this year.
With a HELOC, you have access to a certain amount of money, but unlike a home equity loan, you just use what you need — and then repay this amount all at once or monthly, over time. They’re similar to a credit card, in that you can draw on this money (up to the amount of equity in your home). But unlike a home equity loan, HELOCs tend to have variable interest rates — meaning borrowers are at-risk if rates go up. The average rate for a HELOC is currently about 4%, and you can find rates even lower. (See the best rates you qualify for here.)
While that may sound great, accessibility is an issue: Some banks tightened up lending requirements recently. As NerdWallet notes, to get a HELOC, you’ll generally need: a debt-to-income ratio that’s 40% or less, a credit score of 620 or higher, and a home value that’s at least 15% more than you owe. Here’s what to know about HELOCs right now.
HELOCs may be more flexible than home equity loans, but potentially at a cost
Compared with home equity loans, HELOCs offer a more flexible line of credit, because borrowers don’t have to take out a big lump sum all at once, they only pay interest on the amount borrowed, and HELOCs can be used for any purpose. The catch is that interest rates typically aren’t fixed, so payments can vary month-to month — and the amount you pay could potentially jump significantly.
That means that in this kind of low-interest-rate environment, borrowers need to make sure they can afford higher payments when rates go up, says David Schneider, a financial planner with Schneider Wealth Strategies. “Don’t be fooled by teaser rates,” which might be a low rate for the first six months, because these will likely go away, he says. (See the best rates you qualify for here.)
Indeed, variable rates are the biggest reason that HELOCs can be more challenging to borrowers than home equity loans, adds Brian Walsh, a certified financial planner and senior manager of financial planning at SoFi: “A HELOC rate can pop on people and a few years down the road, put them in a tough position.”
View these lines of credit as a form of emergency cash, to be used primarily for home-related expenses or other emergencies, advises Howard Dvorkin, a certified public accountant and chairman of Debt.com: “Having the ability to pull equity out of your house at any time you want is concerning to me.” Indeed, your home secures this loan, so if you don’t repay it, you could lose your home.
The current market for HELOCs
Given a surge in remodeling activity, there’s been a lot of interest in both HELOCs and home equity loans, Walsh notes. And when used for “productive” purposes — like home improvement projects or paying off debt — these loans can be “fantastic tools” because they offer lower interest rates than credit cards, he adds.
While Dvorkin says he’s “not a huge fan” of either HELOCs or home equity loans, he says they can be useful for funding projects that add value to your home. Otherwise, refinancing your mortgage may be a better option for freeing up money each month, he says.
That said, now may be a good opportunity to obtain a HELOC — even if you don’t end up using it — because market dynamics are favorable, Schneider says. Compared with a year ago, home values have gone up, the unemployment rate has fallen, and interest rates remain low, while banks are more likely to lend than they were in spring 2020, he adds. (See the best rates you qualify for here.)
Still, it’s important to be mindful that if you take much equity out of your home and home prices dip, then you could find yourself underwater on your mortgage, Schneider adds. And don’t get mesmerized by teaser rates that won’t last, he adds.
Beyond shopping around online, check with local banks to compare terms and rates, Schneider advises, because the amount of money for these lines of credit is often far lower than for a mortgage, and local banks may be more likely to extend credit. Assuming you can find a lender, a HELOC is pretty easy to obtain — and there are no closing costs, so long as a homeowner keeps the line of credit open for a certain amount of time, usually 3 years, he says.
“Anyone taking out a home equity line should use it wisely,” Schneider says. “They’re a wonderful tool if used wisely; if not, they can dig somebody into a deeper hole.”